Dimensional Fund Advisors Part II

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

Markets Work, Capitalism Works

This is one of the core beliefs behind DFA. The Director of Research, Eugene Fama, is often credited as the father of the efficient markets hypothesis which is widely quoted within the industry and between investors. However, they will explain that they prefer using the term “equilibrium markets”. This is based on the realization that there ARE mispricings periodically in the market, and efficient market hypothesis is too rigid. But the premise behind it is sound: capitalism works. There are so many people out there watching the markets that any potential mispricings that can be exploited do not crop up often enough. The competition is just too stiff.

It’s possible to beat the market, but it doesn’t happen nearly as often as we think

DFA believes that it is possible to beat the market, and that some managers can do it even after having accounted for chance – in other words there ARE truly skilled money managers out there. The problem then, is that this happens much less often than you think, and there is no way to pick them in advance anyways. There are numerous studies they cite that support this argument, but let me highlight some powerful observations.

Peter Lynch

I’m skipping ahead a bit because we have yet to talk about the Fama-French 3 factor model versus CAPM (Capital Asset Pricing Model), but take my word for now: according to a more improved metric for measuring money manager performance than the one predominantly used now (CAPM), Peter Lynch did indeed provide Alpha (returns greater than predicted by the models). In other words, Lynch was identified as being one of the truly skilled managers who could beat the market. For those who don’t know, Peter Lynch was manager of the Fidelity Magellan fund from 1977 to 1990 during which time the fund returned an annualized 29% per year. He is widely cited as one of the best stock-pickers who ever lived – and I think it is safe to say that he is a better stock picker than you or I could ever be.

The performance of Magellan from 1990 (after Lynch left) until the end of 2006 when compared against the improved model exhibited negative alpha (meaning it underperformed what would be expected when using the 3 factor model). Some people may point out that it continued to outperform the S&P500 – and that is true, but again, you will have to take a leap for now until I explain later: the S&P500 is an almost meaningless benchmark for Magellan. (I will back up that assertion later in this series.)

I don’t think it is a stretch to say that part of Lynch’s job nearing the end of his tenure running Magellan was to select and/or train his replacements. So the moral of this observation is that if Peter Lynch, arguably one of the best stock pickers of all time, cannot find the next great manager, what makes other people think they can?

More to come…

The next part in this series on DFA will look at an observation about Warren Buffett and we will also look at some more research on active management versus passive management.

I’m looking forward to the rest of your DFA series. I agree with you that mispricings occur infrequently because of the competition to find them if we restrict our attention to mispricings that can be exploited over the short term. If I’m to believe Warren Buffett, opportunities to buy stock in businesses that have excellent long-term prospects come up all the time, particularly when the market in general is down. If Buffett were starting over with a few million dollars, I have little doubt that he could find a few small caps that would outperform over the next two decades or more.

If your focus is on next month, then the efficient market hypothesis is quite close to reality. If your focus is on the next decade, then there are mispricings everywhere for the investor willing to understand businesses and their prospects.

@ Michael James – very true, and you hit the nail on the head by using the term “businesses” instead of stocks in that last sentence.

Jordan ClarkAugust 13th, 2008 03:15 AM

I’m very interested in reading this full series of articles, I’m already fully behind the leaps of faith on passive investing and I believe in the DFA fundamentals, but I just don’t know enough to jump on board.

For one thing, I didn’t realize DFA Canada had so few approved advisors, that definitely explains why I haven’t been able to find much information on their products from other blogs or online in general aside from DFACanada.com and IFACanada.com.

I hope that you will cover the difference of DFA in the US compared DFA Canada. In the US their long history shows a very successful product, but the Canadian fund is much newer and smaller. So I wonder if that is causing a drag on it’s performance because it doesn’t appear that many of their funds have beaten their respective indexes since inception (according to GlobeFund.com).

@ Jordan – an excellent question and yes I will address the differences between DFA Canada and DFA USA. Specifically I will also address why the funds have different performances than the indices and how to interpret that. Also, you are quite correct to compare the A class instead of the F class because either will have a 1.00% fee in the end that goes to the advisor – this 1.00% drag must be factored in when making a comparison to DIY ETF investors – some may find that the extra 1% is not worth it. What muddies the waters is that not all planners are created equal either, so what you get for the 1.00% can vary from advisor to advisor as well – this will also be addressed.

[…] expected performance in the Three Factor world, alpha which appeared in a CAPM world may not exist. As I alluded to in Part II of this series, the Fidelity Magellan fund when helmed by Peter Lynch provided both CAPM alpha and Three Factor […]

[…] expected performance in the Three Factor world, alpha which appeared in a CAPM world may not exist. As I alluded to in Part II of this series, the Fidelity Magellan fund when helmed by Peter Lynch provided both CAPM alpha and Three Factor […]